Mary Karen Wills, Partner Beers & Cutler PLLC March 2006

1. National Defense Industrial AssociationCross Border Cost, Accounting and Pricing Considerations Associated with Federal Government Contracts Mary Karen Wills, Partner Beers & Cutler PLLC March 2006

2. Topics • Contracting Considerations • Pricing Considerations • Cost Issues • Cost Accounting Standards Considerations • Government Audit Considerations 2

3. Contracting Considerations

4. Contract Considerations • Contracting method will dictate many cross border issues • Commercial item contract • Negotiated contract • Specific contract type, e.g. cost type, fixed-price, T&M • Contracting agency and associated regulations will also dictate cross border issues • United States government agency • Foreign government agency • Our Focus will be primarily on contracts with United States government 4

5. Commercial Item Acquisition • Commercial item contracts more prevalent • Negotiated commercial item contracts provide for government access and right to examine records related to contract – information other than cost or pricing data • Most Favored Customer Clause Compliance deserves consideration – often included in agreements • Consider how foreign contractors can or will support comparable pricing data for discounts and pricing history—accuracy, completeness and verifiability • Anticipate unique clauses for inclusion 5

6. Negotiated Procurement • If contract exceeds $550,000, the Truth in Negotiation Act applies unless an exemption is met. No special exemptions for foreign concerns. • Contractors required to submit current, accurate and complete cost and/or price information. • Responsibility for subcontractor cost or pricing data could raise issues with foreign companies and ability to substantiate with cost or pricing data. Also consider prime’s responsibility for reviewing cost or pricing data, and how this will be accomplished. • Consider how to accomplish “assist audits” overseas. 6

7. Options for Structuring Foreign Work • Contract/subcontract with a separate foreign company • Contract/subcontract with an existing foreign related party entity • Subsidiary • Division • Branch • Set-up a new related party foreign entity • Joint Ventures and teaming arrangements • Strategic alliances 7

8. Options for Structuring Foreign Work • Tax issues may be important in driving selection of entity • Consider obtaining in-country local knowledge • Many companies outsource accounting and tax functions in-country, especially payroll 8

9. Pricing Considerations

10. Incremental Costs To Include in Cost Estimates or Bid Prices • Many contracts with foreign concerns result in significant incremental costs over domestic concerns. Consider: • International transportation/shipping – impact can often be as high as sales price. Not typically included in domestic bids. • Insurance – multiple handling points and differing risks warrant consideration • Taxes – employee and employer, VAT, local, income taxes • Export licenses, permits and legal fees • Employee Wage Differentials • Foreign currency translation costs • Letter of credit/financing costs 10

11. Employee Compensation Costs • Expatriates or local hires? • Country specific rules and agreements: • Residency • Requirement to pay personal income tax in country and United States • Credit available to United States tax ($80,000 exclusion) (United States, Germany, Italy, United Kingdom) • Compensation differentials often include: • Cost of living increases • Housing • Relocation • Tax gross up • Travel in country and to US • Education expenses 11

12. Employee Compensation Costs • FAR 31.205-6 Compensation explicitly covers allowability for additional income tax resulting from foreign assignments • FAR 31.205-6 also includes limits on severance payments to foreign national performing on contracts outside the US. Amounts deemed allowable up to amounts typically paid in U.S. Other provisions also included. 12

13. Consider Incremental Costs in Pricing Contract • Contract type may dictate need for inclusion of special clauses to ensure adequate recovery of additional costs due to cross-border issues. • Cost-type contract, consider clauses detailing types of costs considered to be reimbursable • Fixed-price contract, consider EPA clause or other clause to mitigate foreign currency exchange risk • Ensure bids include adequate estimates for incremental costs 13

14. Payment Considerations • Complexities can arise in relation to obtaining payments. Consider currency to be used? What exchange rate applies? How payment will be secured? • Clarify payment method in contract, if unusual – eg, advance payments, negotiated payment schedule • Consider ability of foreign entity to timely submit progress payment support • Consider working capital requirements related to progress payments • Consider how to structure payment terms with foreign payors, often letters of credit need to be established by US companies. 14

15. Cost Matters

16. Cost Matters • Certain costing issues arise in connection with dealing with related party foreign concerns, e.g. joint venture, subsidiaries, branches, etc. • These costing issues often arise as entities fulfill contractual obligations using multiple entities of the organization, e.g. borrowed labor, intercompany purchase of products, maximizing existing capabilities. • These issues create a need for supportable transfer pricing methodologies between related party entities. 16

17. Transfer Pricing Example • Entity A provides IT services, installs hardware and performs training. Entity is located in Houston, TX • Entity B is a subsidiary located in India that provides call center services to government and commercial entities. • Entity C produces computer hardware in China only for sale to US Government. • All three entities are collaborating on a US Government contract. How will costing and pricing be performed for all entities? 17

18. Transfer Pricing Issues • Related party entities typically establish transfer pricing policies, that is pricing policies for products or services sales between segments or geographic locations • Transfer pricing includes how the price is determined, e.g. base cost, indirects, G&A and profit to be applied between related party entities • These transfer pricing policies should be established and should ensure consistency of pricing methods • Need to consider whether transfer pricing policies have already been established in CASB Disclosure Statements or GAAP accounting and how they will be adhered to and comply with FAR and CAS. 18

19. Transfer Pricing • Often transfer pricing is determined based on trying to minimize taxes. Typically required to be arm’s length. Arm’s length definition varies by country and is often subjective. • Many times, transfer pricing includes a profit element. • Contractors can use differing transfer pricing methodologies for contract costing purposes than are used for tax or reporting purposes. 19

20. FAR 31.205-26 Material Costs • FAR 31.205-(e) Allowance for all materials, supplies and services that are sold or transferred between any divisions, subdivisions, subsidiaries, or affiliates of the contractor under a common control shall be on the basis of cost incurred in accordance with this subpart. However, allowance may be at price when — (1) It is the established practice of the transferring organization to price interorganizational transfers at other than cost for commercial work of the contractor or any division, subsidiary or affiliate of the contractor under a common control; and (2) The item being transferred qualifies for an exception under 15.403-1(b) and the contracting officer has not determined the price to be unreasonable 20

21. Transfer Pricing for Internal Services • Companies often look to other parts of a consolidated entity to provide not only contract or end product items, but also internal services, like accounting, HR, legal, IT. • Transfer pricing policies, or written MOUs should be developed that detail how these cost transfers will be determined. • These must also be consistently adhered to and used for cost buildup purposes, where so required. 21

22. Cost Allowability Considerations • Federal Acquisition Regulations – FAR Part 31 cost principles do not cover all costs associated with foreign contracts • GAAP (Generally Accepted Accounting Principles) provides guidance on accounting treatment where FAR is silent • International Accounting Standards may differ from US GAAP • Examples, foreign currency translation costs 22

23. Foreign Currency Cost Considerations • Denomination of Contract in local currency or dollars • Highly inflationary economy? Cumulative inflation of approx 100% over 3 year period • Stability of local currency? • Ability to hedge exchange risk. Assess historic exchange rate risk and economic data for future. • Contract Type – contractor assumes foreign currency risk in fixed-price contract. Consider including EPA or other adjustment clause to mitigate risk. (Elter S.A. case, ASBCA No. 52441, 01-1 BCA) 23

24. Foreign Currency Cost Considerations • Foreign Currency Translation Costs typically treated as allowable costs • No mention in FAR Part 31 cost principles • GAAP – Statement of Financial Accounting Standard No. 52 (SFAS 52) • Exchange gains and losses recorded under GAAP represent allowable costs • GE Case – Government originally disallowed a portion of depreciation charges on spare parts order. re translation of depreciation expense “in converting into dollars the depreciation cost of a contractor’s foreign affiliate whose local economy is highly inflationary, historic exchange rates must be used. 24

25. Cost Accounting Considerations

26. Cost Accounting Standards (CAS) • Foreign contractors and subcontractors are subject to the same CAS and Disclosure Statement requirements applicable to domestic firms. • However, in lieu of filing a CASB DS-1 Disclosure Statement, a foreign concern may, with CAS Board approval, use a form prescribed by an agency of its government. • The CAS Board has approved alternative forms for contractors from Canada, Federal Republic of Germany and the UK. 26

27. Cost Accounting Standards Coverage • If contract value exceeds $50 million or $50 million of CAS covered contracts in last fiscal year, full CAS Coverage (19 Standards apply) • If contract value exceeds $7.5 million, modified CAS coverage (4 Standards apply) • Disclosure Statement required at full CAS Coverage (consider Home Offices and Segments) • Must consistently follow disclosed practices 27

28. CAS Considerations • CAS provides an exemption for: • Contracts and subcontracts executed and performed entirely outside the U.S., its territories and possessions (may go away?) • Contracts and subcontracts with foreign governments or their agents and instrumentalities • Contracts and subcontracts awarded to foreign concerns (except CAS 401 and 402) • Subcontracts under the NATO PHM Ship program to be performed outside the US by a foreign concern 28

29. UK CAS Disclosure Statement Considerations • UK contractors are allowed to substitute the UK QMAC “Questionnaire on Method of Allocation of Costs” and recent Supplemental QMAC for the DS-1. • QMAC consists of 9 schedules detailing general accounting system disclosures, along with bases for recovery of indirect expenses, and detailed supporting schedules. 29

30. CAS Considerations • Note that when a subcontract is awarded under a CAS-covered prime contract or higher-tier subcontract, CAS coverage of the subcontract is determined in the same manner as it is determined for the prime contract. • Ensure that prime contract is CAS covered before assuming subcontracts are subject to CAS! 30

31. Government Audit Considerations • DCAA presence limited overseas • Foreign audit agencies experience and capabilities differ • Consider • How to affect assist audits on foreign companies • Financial capability assessments • Indirect rate agreements • Forward pricing agreements 31

32. Tips for Consideration • Include contract clauses regarding treatment of unique costs as allowable and reimbursable, or determine the basis will be used to determine allowability • Consider impact of potential contract termination and how termination recovery will be determined, including cost differentials • Anticipate incremental costs to maximum extent at time of proposal preparation or contract negotiation • Put cost differentials in bids • Employee compensation • Taxes 32